Why income is more important than it used to be

Income, as we know, is nice to have. No doubt people with financial success are right when they say “I’ve been poor, and I’ve been rich, and rich is better.”

Income matters to mortgage lenders in a big way. Since 2014, lenders must evaluate most borrowers using the federal Ability-to-Repay (ATR) standard. The rule says that lenders must be certain that borrowers have the financial strength to repay the debt.

Affordability calculation

Lenders want to know what you make, and also what you spend for accounts like credit cards, housing, car payments, and student debts. They then compare your recurring monthly debts with your gross monthly income, what they call the debt-to-income ratio or DTI.

If before taxes you earn $5,000 a month, and apply for a loan with a principal, interest, property taxes and homeowners insurance (PITI) of $1,000 a month, you’d spend 20 percent of your income on housing. Many (but not all) lenders don’t like to see this number exceed 28% to 32%.

Your DTI includes the proposed house payment, plus your other monthly accounts, but not normal living expenses like food or utilities.

So if, in addition to your proposed $1,000 PITI, you pay $500 a month for your car, $250 for credit cards and $250 for a student loan, your DTI is 40% ($2,000 / $5,000).

What’s too much debt?

So how much debt is too much? Different loan programs are okay with different DTI levels. For instance, FHA-insured mortgages generally limit DTI to 43%, but will go as high as 50% if you have certain “compensating factors.”

Those include buying an energy-efficient home, having very good credit scores, showing conservative use of credit, or having substantial savings balances.

If you have a gross monthly income of $6,000, FHA guidelines might allow $1,860 for housing costs (31%) and $2,580 for all monthly accounts including housing (43%). In effect, you can have $720 for such monthly costs as car loans, student debt, and credit card bills and still meet the DTI standard.

VA is a little different

With the VA, you can have a DTI up to 41 percent, and it doesn’t matter how much goes for housing and how much goes for other debts. If you have no other accounts, you might actually apply the whole 41 percent to a mortgage.

(The FHA now has a similar approach for thrifty borrowers: It will allow ratios of up to 40% for housing if you have no debts and solid credit.)

In addition, the VA allows another, more forgiving calculation called Residual Income. If you don’t qualify with the DTI ratio, lenders must also apply the Residual Income standard to see if you meet that guideline.

Conforming DTI depends on credit and down payment

Conforming loans sold to Fannie Mae and Freddie Mac have maximum ratios that depend on your down payment and FICO score. The DTI limit generally ranges between 36% and 45%.

However, there are now programs like HomeReady and Home Possible, which can allow DTIs as high as 50%.

While it might seem enticing to get mortgage financing with a 50 percent debt-to-income ratio, borrowing with such a steep DTI can be risky in the event of a layoff, downsizing, or other loss of income.

What’s worse? Low income or credit score?

It might seem as if someone who can pass the DTI barriers will sail right through the mortgage application process. While the right DTI is a must, it’s not the whole game. Lenders also want borrowers to meet other standards, especially a solid credit history

The important point here is that income and credit are not the same thing. Income represents a borrower’s ability to repay, and that’s important. But if the borrower is not also willing to repay his or her debts as agreed, the income doesn’t matter.

Lawyers and doctors can earn a lot of money, but some have lousy credit. How does this happen? They’re not using their money to pay bills.

From the lender’s perspective, income is good, and a lot of income is better. But borrowers who don’t pay their bills represent a lot of risk, regardless of how much they make. How do lenders determine your willingness to repay? They check your credit scores.

The table below shows the distribution of credit scores for approved loans, courtesy of Ellie Mae. You can see that most approvals are for applicants with FICOs 700 and up for non-government (conventional) loans, and 650 and up for FHA financing.

What’s a good credit score for a mortgage?

Imagine that Ms. Smith makes $600,000 a year and has a 550 credit score. The income is great, but that credit score is a huge red flag. Either Ms. Smith will not get financing or lenders will require a massive down payment and possibly a steep interest rate.

In general terms, FICO – the credit scoring company which dominates the industry – says scores rank like this:

800+ – Excellent

740 to 799 – Very Good

670 to 739 – Good

580 to 669 – Fair

579 and below – Poor

Importantly, someone with excellent credit – 800 and above – presents about a 1 percent chance of paying late. Someone with a score of 579 or below has a 61% chance of delinquency.

If you’re a lender, it doesn’t take a lot of head scratching to figure this one out: Someone with a poor credit score is 60 times more likely to be delinquent than someone with strong credit.

What to do about a low credit score

There are several ways to overcome a low credit score when looking for a mortgage.

First, look for mortgage programs which are open to those with low credit scores such as the FHA, VA, or USDA programs.

Second, make a larger down payment. FHA allows loan approvals for scores as low as 500 if you put at least 10% down, but only to 580 with 3.5% down. In general, the lower your credit score, the more you should put down.

Third, go to the government site, AnnualCreditReport.com, and check your credit report. (You are allowed to get one free credit report every 12 months from each of the three major credit reporting agencies.)

The bureaus must investigate and correct errors once you bring them to their attention. If time is of the essence, your lender can bring in a “rapid re-scoring” service that can fix reports quickly for a small fee.

Fourth, sit down with a non-profit credit counselor or financial planner paid (who works for fees, not commissions) and work on your credit, savings and debts until you are financially healthy.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.